How Natural Gas and Oil Prices Are Linked

By Eli Neusner

Ed Kelly is vice president, North American gas and power, at energy research and consulting firm Wood Mackenzie. In his role, Kelly keeps close tabs on the linkage (or lack thereof) between the price of natural gas and oil. Commodities investors will be particularly intrigued by Kelly's recently published report on the natural gas-oil linkage. We caught up with Kelly in his Houston office.

HardAssetsInvestor.com (HAI): Was there ever really a linkage between natural gas prices and oil prices, and will we ever see it again?

Ed Kelly (Kelly): Yes, as a matter of fact, there was a strong linkage between natural gas and oil prices that started in the late 1990s and lasted all the way to Katrina in 2005 and beyond.

Natural gas is its own animal, but there are two sources that create a linkage to oil. One is psychological - the same commodity traders work in both the oil and natural gas markets, so they think they're interchangeable, even if market fundamentals are different. There's also historically been a physical source for the linkage based on the supply of natural gas. In the late 1990s, gas started pricing above its natural ceiling price - the price of residual oil, which is what's left over once you refine the petroleum. That's because there wasn't enough supply of natural gas, and because the price of oil was declining, hard as that is to believe.

HAI: How long until the linkage reoccurs?

Kelly: First, let's look at what happened to break the linkage. The oil price began to soar, while natural gas came under pressure due to increased North American supply.

But long term, the era of North American natural gas selling at a relative discount to oil will end. It depends on a few things, but mainly it comes down to the race between U.S. domestic natural gas supply and our growing reliance on gas for generating power. We have enough domestic supply in the reservoirs to insulate natural gas prices from rising oil prices over the next 3-4 years, but after that, we forecast that there will be a relinkage to the oil price.

HAI: What does that relinkage mean for the price of natural gas?

Kelly: It means that if current market conditions of $100/barrel oil continue, then natural gas could rise to as high as $13-14 BTU. Today it trades in a range of $7-$7.50 per BTU [British thermal unit].

HAI: Why isn't the relinkage already happening?

Kelly: It comes down to greater supply of natural gas. Thanks to high natural gas prices and better drilling technology, we have seen record drilling levels which have resulted in higher domestic supply. That will be enough to delay the relinkage for the next 3-4 years. We think that most of the domestic supply growth will come from unconventional resources, such as gas from shale, dense sandstone - known as tight gas - and coal bed methane. Shale gas alone will contribute between 50-60% of all net U.S. production between 2007 and 2011. These unconventional sources are plentiful in the U.S. and only in the early stages of being developed. As I said, growth in these sources has been made possible by new technology advancements in horizontal drilling and fracturing.

HAI: Then what happens after 2011?

Kelly: Well, after 2011, we forecast a relinkage to the price of oil. This will happen because our domestically produced natural gas will be consumed by a growing demand for gas-fired power generation. This will trigger the need to import more liquid natural gas. When that occurs, U.S. gas prices will then become linked to worldwide prices for LNG [liquefied natural gas] cargoes - prices that are set by indices, including those for crude oil prices. Under present market conditions [oil prices over $100/bbl], a relinkage of natural gas and crude oil prices would mean the $13-14 gas prices that I mentioned before. It could be more painful than that, but it all depends on how high oil prices rise.

HAI: What other factors will signal to commodity investors that the relinkage is on the way?

Kelly: We think that other key variables that will affect the price of natural gas include the level of economic growth, the impact of environmental regulations on the use of coal to generate power, and of course, the productivity, or not, of new shale gas plays, and on the availability of other nonconventional sources.

Comments

[BrotherMaynard:]

"Why isn't the relinkage already happening"

Probably because everyone assumes oil is going to $70.

2008 Sep 12 04:50 PM

[G23ROCKS:]

Great article, especially the forecast of LNG pricing. I'm in XTO and UNG, and also like CHK.

2008 Sep 12 06:53 PM

[Urbane Gori...:]

If T. Boone gets his way, then watch oil go down while gas goes up.... jegan ;-)

2008 Sep 12 07:08 PM

[john s. gordon:]

new supply - lots of methane hydrates under the permafrost in northern canada & alaska.
> jack

2008 Sep 13 08:42 AM

[Managing Ed...:]

The seasonal shrinkage of the crude oil premium to natural gas is already under way. Since Labor Day, the spread's narrowed $1.557 per mmBTU, or 16%. That would yield a $9,590, or 63%, return on margin for a 1:1 spread (long NG/Short CL).

See the Hard Assset Investor article, "Spreading Oil And Natural Gas" at www.hardassetsinvestor... for details.

2008 Sep 13 10:07 AM

[PhD2B:]

The article reads: "Today it trades in a range of $7-$7.50 per BTU [British Thermal Unit.]" A wooden kitchen match produces about one BTU. I believe the author meant to say per MMBTU.

2008 Sep 13 12:39 PM

[howsie:]

A barrel of oil has a heating value of of about 6 million BTU. At $100 per barrel this is equal to $16.67 per million BTU. Thus, on a thermal linkage, the price of natural gas would be $16.67 per million BTU or per 1000 cubic feet(heating value of NT is about 1000 BTU/cubic foot).

2008 Sep 13 04:36 PM

[intl.risk:]

Actually, linkage started in late 1970s, early 1980s when Japan agreed to use Japan Crude Cocktail as escalator for LNG import contracts and Western European countries linked Russian gas pipeline and Algerian LNG imports to heating oil. US refusal to accept link at the time is why Algeria unilaterally abrogated its LNG export contracts with US companies in 1980.

2008 Sep 17 04:30 PM